The trouble with 401(k) loans

Borrowing money from your own retirement stash may seem like a good idea, but there are some major consequences to consider.

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By Walter Updegrave, Money Magazine senior editor

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

NEW YORK (Money) -- Question: Some of the people I work with are taking loans from their 401(k)s. They say it's better to withdraw the money and pay yourself back with interest rather than see your 401(k) balance continue to go down. I can borrow up to $30,000 for five years. Do you think it would be a smart move to take out the loan? --Val, Tanner, Alabama

Answer: In a word, no.

I've gotten many emails lately from people who seem to believe that by borrowing from their 401(k), they are enhancing the safety of their retirement savings and even boosting their returns since they're paying back the loan with interest.

But if you really examine this scheme, you'll see that you're probably not increasing the return. And far from improving your future retirement prospects, you may actually be undermining them.

The drawbacks

Let's start by taking a closer look at this notion that by borrowing from your 401(k) and then repaying with interest means that you are earning a "return."

I know from emails I get that the idea of "paying interest to yourself" has a powerful appeal to many people. But think about it. When you repay the loan, you're paying yourself back with money you already have. All you're doing is taking money out of one pocket and putting it into another.

Granted, you are saving that money rather than spending it. But you don't have to take a loan from your 401(k) to do that. You can save it simply by boosting your 401(k) contribution or, if you've already maxed out, putting the money into an IRA (assuming you qualify) or even a taxable account.

In any case, by borrowing and repaying the loan you're not bringing new outside money into your coffers as you are when a third party pays you interest or you earn capital gains on an investment.

In fact, you're actually a bit worse off by borrowing the money. Why? Well, when you pay the interest on your 401(k) loan, you do so with after-tax dollars, money on which you've already paid income taxes. When you later withdraw that money from your 401(k) in retirement, you'll pay income taxes on it again. Which means the money you use to pay yourself interest is being taxed twice. So you're giving away more of your money to the tax man than you have to.

Now, I'm sure there are some people out there saying, ah, but you don't understand. After I take out the loan, I'm going to invest this money. And as long as I earn a higher return on it than the rate I'm being charged for the loan, I'll come out ahead.

Well, that sounds nice, but there's no guarantee that whatever investment you choose will earn a higher rate. So the underlying premise -- i.e., that you can get a free lunch by skimming off the difference between loan rates and investment returns -- may not hold. And it may very well backfire. If you're not convinced of this, just ask a few hedge fund managers who got hurt this year trying to amplify their returns by investing borrowed money.

Besides, this plan of taking a loan and then investing the proceeds outside your 401(k) implies that somehow it's the 401(k) plan that's limiting your ability to earn decent returns. But that's not the case. Most investments are delivering paltry returns these days because economies worldwide are struggling.

The risks

As for the idea that a 401(k) loan will enhance your retirement security by preventing your balance from going down, well, that's a non-starter too. The fact is that borrowing may actually put your retirement savings at greater risk.

The reason is that if you take out a loan and later switch jobs or are laid off, you must immediately repay the loan. If you can't -- maybe your sure-thing investment lost value or perhaps you ended up spending some of loan proceeds instead of investing them -- any unpaid loan balance would be considered a distribution from your plan. You would owe income tax on that amount. And unless you're 55 or older, you would also be hit with a 10% early withdrawal penalty.

This is a risk anyone contemplating a 401(k) loan should always keep in mind. But it's an even bigger danger today considering that companies are looking to shave payroll costs and unemployment is on the rise.

Protect your money

So if borrowing isn't the answer, what should you do to protect your 401(k)?

Well, to begin with, I don't believe you should be thinking in terms of "protecting" your 401(k) per se. Sure, you don't want to see it vaporized. But also don't want to get swept up in the fear and panic of the moment.

Remember, your main goal is to invest your 401(k) in a way that boosts the odds that it will be able to support you throughout retirement. The way to do that is to invest in a mix of stocks, bonds and cash that's appropriate given such factors as your age, the amount of money you'll need to live comfortably in retirement and the level of risk you're able to accept.

But even if you're so worried that you can't bring yourself to take the longer view and build a diversified portfolio, there are still better responses than taking out a loan.

If you really want to assure that your 401(k) balance doesn't take a dive even for the short term, you can always move a chunk of your money into the less volatile investment options, such as a stable-value fund, capital preservation fund, a short-term bond fund or a money-market fund.

Again, I don't recommend that you move all your money into such options. But doing that would be better than taking out a 401(k) loan to safeguard your account's value.

Bottom line: There may be times when you may need to borrow from your 401(k), say, to finance a child's education, buy a house or fund a home-improvement project (although, even in such cases there may be better options).

But borrowing from your 401(k) as an investing strategy? That's more likely to create problems than solve them. To top of page

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